Reference no: EM132536227

Question - Suppose Tecent Holdings is considering purchasing Baidu, Inc. The current (as of 4/13/2015) market capitalization of Tencent Holdings is $100 billion with a capital structure of 30% debt and 70% equity and 2 billion shares outstanding; and Baidu, Inc. is valued at $50 billion with a half-half debt/equity capital structure and 1 billion shares outstanding. Equity beta of Baidu is 2.25 and Tencent is 1.2. Both firms' debts are riskless. Market risk premium is 10% and the risk-free rate is 5%. There is no synergy between the two firms in cash flows. Then on April 14, 2015, Tencent Holdings announces that it will indeed acquire all of Baidu Inc.'s operations and businesses. When asked by the media, Pony Ma responds:

"We are purchasing Baidu Inc. to lower its cost of capital which will be derived from diversifying operational risks. This benefit will surely increase the value of the merged firm."

(1) What is the share price of each firm before the acquisition?

(2) What is the weighted average cost of capital of each firm before the acquisition?

(3) What will be the weighted average cost of capital of the combined firm?

(4) Evaluate Pony Ma's statement. Has there been a reduction in the overall cost of capital? Was this move value accreting (i.e. an NPV-positive move)? Why or why not?